Years/Purchase Ratio

One of the few tools which measure return is " years/purchase ratio " ( gross rent multiplier ).
This represents the number of years of rent needed to buy the property at its current price.
Eg :
If the block of flats is offered for $ 1 million and it generate $ 100 000 a year in rent, it would take 10 years of gross rent of $ 100 000 to equal the offer price of $ 1 million.
This ratio is used in a similar way to the P/E ratio ( price / earning ratio ).
When the year/purchase ratio is high for particular property, either it is overvalued or the whole property market is overheated.
Question :
What value might represents fair / undervalued property?.

Hi Tropo
Sorry I don't know much about this return theory, though I have read it mentioned in a book somewhere (the title has slipped my mind though).
I tend to stick to historical returns to forecast future ones when it comes to property and also favour a mixture of cg and rental return when measuring a property's value. Eg 15% total return which can be both cg and rent.
Hopefully someone more experienced than I can soon comment on your post

This is a general comment only and does not constitute advice. Before making financial decisions you should seek advice from a professional adviser, who can take into account your specific circumstances and investment goals.

I've used a number of methods for purchase, and, for me, it depends on the purpose of the next project - buy, hold, reno, develop, as to which strategy I use. In general like Jacque, I like a cordial mix of cg and income. So I consider many variations along the way.

Dave,
I have been thinking how to correlate Steve's Rental Reality with year / purchase ratio under one equation.

Alan,
Years/ purchase ratio around 5 -10 is a buy !!.
Question is what to do if the same ratio hit 20 or more ?.
Eg:
House price $ 350K. Rent say .... $ 300 / week.
Year / purchase ration in this case = 22.4
So - is it still a buy ??.

Have never read any of his stuff but I believe Hans Jakobi has his RTP (rent to purchase price ratio) as an important element to his various courses etc..........the idea is to be cashflow positive before tax advantages.

I believe it is basically $100 rent for every $50k in the price which works out to about a 10% rental yield or you don't buy. Haven't heard how people have gone using his criteria but I'd be very happy to find a quality property that offers a 10% rental yield.

Steve McKnight used to talk about his "10 second rule" (which I think other people use too) ... simply put - look at the expected rent for a property (dollars per week), divide that number by 2 and times it by 1000 ... this gives you the MAXIMUM price you should pay for it to still be cashflow positive.

Example:

Rent $250 per week

Maximum purchase price = (250 / 2) * 1000 = 125 * 1000 = $125,000

Just to check, if you work out the yield, you'll see $250pw rent (= $13000 pa) / $125,000 = 10.4% yield ... (although the "rule" actually works out a 10% yield - it's simpler).

So the "divide weekly rent by 2 and times by 1000" rule is a very quick way of working out how much you should be paying.

Of course there would be very few properties left after our last boom that would meet this criteria - you might find some if you look hard enough. I guess that's one of the reasons why Steve M has been buying in NZ - not enough decent stock that met that criteria locally.

Alan,
Years/ purchase ratio around 5 -10 is a buy !!.
Question is what to do if the same ratio hit 20 or more ?.
Eg:
House price $ 350K. Rent say .... $ 300 / week.
Year / purchase ration in this case = 22.4
So - is it still a buy ??.

Click to expand...

If the average Purchase Ratio over 5-10 years was 20 eg. Yr 1=22, Yr 2=18, Yr=21, Yr=19 etc, then if the current Purchase Ratio is below 20, then it may be worth investigating further......

If the ratio was 22.4........probably not........if it was 18.5......look closer.....

Same case as above = out of reality. After all what you can buy for 125 K ??.

Click to expand...

Well - it's out of reality in many locations now, but only because we've just has a boom ... I bought an IP (actually a pair of IPs) back in late 2001 that easily met that rule ... and I used the rule when considering them too.

Just for the sake of clarity the McKnight rule that Sim quoted is just another way of describing exactly the same mathematical relationship in my post re Hans Jakobi - dunno who decided on that first.

Agreed regarding the chances of finding that sort of deal in any sort of reasonable area currently , unless you have the inside running on a major infrastructure milestone about to hit a rural backwater.

Presumably this type of investing requries concentrating on areas with a very poor history of capital growth and , even then, only at select times in the business cycle. Not a strategy that really meets with my idea of investing as you are able (with some exceptions based on some basic cycle analysis) and concentrating on prime inner urban capital growth areas.

Can't you just use a kind of Price Earnings ratio like you do for shares?

I.e. Say a property is listed at $350,000 and is renting for $390 pw

the PE would be 350k / (390 x 52) = 17.26.

Looking at it another way this equates a rental yield of 5.79% (i.e. $20,280 annual rent / price).

Then look at comparatives for the area. If similar houses are all selling at a higher PE it MAY be a bargain. I guess that's also the weakness of PE's it is always only a comparative measure...i.e. measuring against similar (in this case) houses.

One twist is that I also tend to look at my FORECAST of rental post renovation (but also factor in the estimated reno cost to the price). This can go some way towards quantifying the value you can create through reno.

If you're looking at only a revenue stream without too much concern about growth then valuation is more precise. But otherwise I don't think valuation is a precise art when you're aiming for growth (or are planning to create the equity through value-adding). Whilst you DO need to put a price on the value of say subdividing a block, adding an extra storey etc, the ability to do those things may lead you to pay a price which seems a lot when looking purely at the rental return.

Just some thoughts.
N.

Nigel

This is a general comment only and does not constitute advice. Before making legal or financial decisions you should seek advice from a professional adviser, who can take into account your specific circumstances and investment goals.

Good idea !!.
I wonder if rental yield of 5.79% is good enough...(no experience in real estate).
I would think that bottom line is about 7% - but I might be wrong on this !!.

Correct valuation, growth and return is my prime concern.

Click to expand...

The thing that is difficult of course is predicting what the future growth will be. You know that today it is rented at say $190pw. But how do you judge whether property A will outperform property B in terms of growth - cause it's growth that will make you wealthy!

I think then you turn to those subjective elements which I guess are akin to qualitative analysis of shares. I.e. "what competitive advantage does this company have in its industry?" perhaps becomes in the property context "what makes this property unique/better for growth than another?". It's here then that we look to historical growth patterns to try to divine what the drivers of growth are...a whole separate debate in itself I guess!

7% return...hard to achieve. Yields in Sydney are well below that atm.

Cheers
N.

Nigel

This is a general comment only and does not constitute advice. Before making legal or financial decisions you should seek advice from a professional adviser, who can take into account your specific circumstances and investment goals.

General rules regarding P/E for property don't really work. The reason is that each area (post code) is different from others. Each post code has its good and bad attributes and the sum of these results in more or less rent achievable in the different areas. Likewise, each property in each area can be different . . . in other words adjacent properties can achieve different rentals.

Price to earnings with shares is something that is prescribed to the various market sectors. So there will be a different P/E for the energy sector to for example the finance sector.

With property, each post code is a "different sector"!
And there are thousands of post codes.

To apply a formula like the 10 second rule to Point Piper and to Country NSW is clearly unworkable.

Hence Rental Reality:
Rental reality prescribes a formula to each individual area and is based on what THAT area has been able to achieve over the previous 5 years. Each area has its own desirability level which will attract tenants to rent there. Also, areas change over time, hence the 5 year moving average.

Example:
Post code 1234:

Rental Yield
5 yrs 6.2%
4 yrs 6.0%
3 yrs 5.5%
2 yrs 4.9%
1 yr 4.3%

This trend of declining yields might be typical of most areas over the past 5 years. The reason for the declining yields is that rents have not kept up with price increases.

The 5 year average yield for this particular post code is 5.38%

Once again each post code, depending on the relative strengths and weaknesses of the area will have it own unique 5 year yield average. This formula then is based exactly on what tenants are actually prepared to pay to live in that particular area.

Rental Reality is: Actual Rental achievable X 52/ 5 year average yield percentage of that area = Real Value of the property.

How to ascertain the actual rental:
1) The property is actually rented.
2) Similar properties in the same street / area
3) Rental estimates from about 5 RE agents for the property.

Let us assume that the achievable rent comes out at $375 per week for the example property. Note once again this is NOT just someone’s opinion; it is actually what the 'market' is saying about what the property is worth in rental terms.

Then:
$375 X 52 = $19,500/5.38%

Real Value of the property = $362,454

The formula applies to each individual property in each individual area.